LSA's take on Cryptocurrencies Life Strategies Analytics (LSA) is an investment research firm who helps our office to build investment portfolios for our clients. Below is an article LSA published in April of 2020 which details their views on crypt-currencies. Please be aware that our office is prohibited from directly investing in crypto-currencies due to their unregulated and highly risky nature.With any newer and harder-to-understand product, it’s important to take a step back and not lose sight of the forest for the trees. From that vantage point, a buyer of any asset considered ‘investable’ should believe that it makes basic economic sense, is durable to some degree, and/or fulfills a special need. For crypto, the jury might still be out. It goes without saying that when speculation in hard-to-value assets are involved, any invested funds should be considered within an investor’s overall risk budget.From a conceptual standpoint, it’s probably helpful to separate ‘cryptocurrency’ from the ‘blockchain’ technology upon which it’s based. Aside from one’s views on crypto, blockchain appears to be useful in some capacity as a modernized and transparent digital ledger for contracts and other records, where having a documented permanent chain of ownership is useful. It’s not hard to see how such records could replace the legacy use of paper contracts, which are cumbersome in a world demanding speed.Cryptos are considered by most to be alternative currency. One classic definition is as a medium of exchange. Bitcoin might meet that hurdle to some extent now that it’s being more accepted as a payment mechanism, and is listed as an option for some online funds transfer options (similar to PayPal). This is potentially also true for ethereum and maybe a few other cryptocurrencies, but that’s about the extent of it. Are these mediums of exchange liquid and easy to convert to other assets? Again, perhaps true of bitcoin and a handful of other brands, but it’s not as obvious for the other few thousand cryptos with lower name recognition and usage. Prices for all are volatile, and can result in large gains or large losses for investors (and transactions are deemed taxable by the IRS). Do these pass the test as an effective medium of exchange? For the large cryptos, perhaps, but it’s less clear about the rest.What backs a particular currency as a store of value? Again, it’s helpful to take a step back from the enthusiasm to see what’s really present. Well-accepted currencies like the U.S. dollar are backed by the economic, taxing, and military powers of the U.S. government, and its immense asset holdings (federal land, precious metals, etc.). Less tangible but important backing comes from accepted cultural conventions, such as political stability and rule of law, that have created an environment of trust surrounding the dollar globally. The U.K. pound, euro, Japanese yen, and Swiss franc are also well-accepted as globally-desired currencies, due to the underlying trust holders have in the assets and policies of these nations. Both tangible and intangible factors have resulted in their relative price stability over time. Cryptocurrencies, on the other hand, have experienced the type of volatility more in line with the stock market. This instability tends to run counter to the desired predictability for a major currency, especially one used as a global medium of exchange. (Would a buyer feel comfortable seeing the price of a new car change from $20,000 one month to $60,000 the next?) An advertised trait of cryptos is that they aren’t reliant on any single government or economic bloc for support, nor can they be subject to central bank monetary policies. The independence has been seen as a strong benefit, especially with the opinion of some that major governments are spending too much money, threatening long-term currency values. However, if something bad happens, it also means there is no authority with deep pockets to step in and provide support, either.It’s helpful to have that backdrop to compare cryptocurrencies with conventional ones. Bitcoin has developed a crowd following, and seems to have the benefits of a network effect. This is due to it being an early mover in the space, and stated limitation of total ‘coins’ that will be produced. Unfortunately, some crypto investors may have a harder time understanding what they own, with only a ‘hope’ that it rises in price, and intention to sell to others at a higher price. In that sense, it could be more appropriate to consider these more speculative in nature as opposed to mainstream currency alternatives, at least at this point in time. This makes them more akin to an emerging market currency, or even a penny stock or stock option. (Again, the most durable currencies have tended to not be speculated in for hopes of big gains—aside from leveraged futures markets, that is. The currencies used in most global trade have been more stable than volatile, which is the reason why they’re used in the ‘medium of exchange’ capacity.)Moving away from the most liquid and recognized cryptocurrencies, where name recognition and network user effect has created a market, the next tier of digital currencies could potentially be in the thousands. If a cryptocurrency is that easy to create and introduce to the world, with so little information about their backing and liquidity, risk rises tremendously. This is not only price risk, but risks of operational problems, and fraud. In a sense, some appear more like rewards programs, to the same degree that airline miles or grocery store coupon points are ‘currencies.’ As in many emerging industries, dilution between all of these cryptocurrency products could create a handful of winners and many losers. The fact that only 180 national/regional physical currencies exist today (according to the United Nations), some with fairly little liquidity, shows that the marketplace is not unlimited. In one example, it’s our understanding that at least one well-known cryptocurrency was set up as a joke by its founders, and has since taken off due to the novelty, with help from online message boards to ‘pump up’ the value. What makes one coin better than a dozen or thousand others one could pick from? Another risk is technological. If new processes are invented, which reduce transaction times, fraud/theft risk, electricity use, or other hurdles, it’s easy to see new winners emerging. Of course, this was said about bitcoin a decade ago, with many predicting its immediate downfall—yet, it lasts.There is also the increasing risk of individual governments creating their own cryptocurrencies (most G10 currency transactions are electronic to a large degree anyway), which could change supply/demand dynamics for the current privately-issued coins. Originally, the most attractive feature of bitcoin and cryptocurrencies generally was their anonymity and lack of affiliation with a government central bank. This was seen as a benefit for privacy reasons (a criticism is that these can be used in illicit transactions, but so can paper cash), and as a potential safe haven from inflation or devaluation of major country currencies. All else equal, these features remain selling points, but seem to have taken a back seat to price speculation lately.Of course, there are more risks. What happens in the event of widespread hack and crypto theft? (These have already occurred.) What authority is really in charge to help restore confidence and asset values? Secure storage is an important issue for all digital assets, as online sources haven’t always been foolproof. The Coinbase IPO this month (with a market cap of over $85 billion) has elevated visibility on the liquidity/trading side, but security problems haven’t been solved. There is also the possibility of governments regulating or even outlawing the use of crypto, outside of their own perhaps, which could threaten the value of existing products (meaning the chance of a current coin becoming worthless isn’t zero). For instance, China has tried to circumvent the use of crypto, to prevent capital flight and evasion of surveillance. What if the power goes out? This is a problem for all digital assets, with digital money being adversely affected at an inopportune time. Speaking of energy, cryptocurrencies like bitcoin that require ‘mining’ (coins are given as rewards for solving math puzzles) require immense amounts of electricity, which hasn’t been earth-friendly.Opinions in the economic and institutional investment communities remain split, between those thinking crypto is a viable investment alternative and those skeptical about durability, compared to classic tangible assets like precious metals. Firms that have moved into the crypto business tend to have a much more bullish view on the industry’s prospects, unsurprisingly. Interestingly, few fund firms or brokerages generally have been outright bearish on the space, despite the risks, perhaps in order to preserve their option of providing crypto-based products or services in the future. A few exchange-traded funds that own crypto have opened abroad, with the U.S. SEC still under pressure to make a definitive call on domestic products. The prices of current strategies have diverged from their underlying net asset values, due to a liquidity premium—investors have placed a value on the ease in ‘one button’ crypto exposure, as opposed to vetting custodians and exchanges, needing to open a digital wallet, etc.In short, for investors in crypto, it’s probably a prudent approach to focus on the more-accepted brands, which also tend to be the most heavily traded. Inflation opinions are mixed, with as many arguments against a sharp rise than for it; the newness of crypto makes the potential reaction to inflation unclear. In all fairness, traditional currencies and cash-like instruments haven’t fared that well on an inflation-adjusted basis over longer time frames, either. Better traditional hedges against inflation include equities (unless it becomes extreme), real assets like commodities and real estate, possibly TIPs, and foreign assets (if the dollar weakens relative to history or other currencies).Are cryptos in a bubble? As with any historical bubble events, that’s hard to answer in real time. However, the level of general excitement, the FOMO (fear of missing out) component, and lack of discussion about downside risks might point to something. Related assets, such as blockchain derivatives called NFTs (non-fungible tokens) have also become popular. Some NFT pieces in the art world like digital photos, videos of famous NBA dunks, etc., have been selling for astronomical prices. Perhaps this could either be the start of a new futuristic trend or an odd footnote in a history book at some point.